Farmers were sold financial instruments that major companies manage through specialist departments, says the man responsible for the interest rate swap management programme at giant Auckland water provider Watercare.

Jason Isherwood, Watercare's treasury manager, says companies must have deep balance sheets and high levels of sophistication to take on the risk of complex and volatile interest rate swaps.

The latest Watercare annual report revealed a $60 million loss on interest rate swap contracts in the year to June 30, highlighting the risks of derivative positions on interest rates.

Isherwood said that although $60m was not a "pretty number", it was relatively modest in the context of Watercare's balance sheet.

The Commerce Commission is continuing early stage inquiries into the sale of similar instruments to farmers in 2007 and 2008 by banks including Westpac and National Bank. The swaps were sold as protection against rising interest rates, but had the effect of locking farmers in to high rates just before a steep and prolonged downturn.

Claims of interest rate swap misselling prompted a national scandal in the UK with the Financial Service Authority finding banks culpable of mis-selling swaps to tens of thousands of unsophisticated small and medium-sized businesses.

In a statement the Commerce Commission may take note of, Isherwood said interest rate hedging was suitable for large organisations with big, long-term debts as it allows greater control over the long-term cost of funding by locking in attractive rates when available.

"I believe that you need to have a dedicated treasury function to adequately manage these risks and it needs to be staffed by people with market expertise," Isherwood said.

"It needs to have adequate systems as well to monitor the risks and report on those risks so that at any point in time you can tell your exact risk position."

Because derivatives exposures can be volatile, companies not only need to be able to understand when things are moving against them, they also need to be able to pay break fees should they need to shut down their exposure.

"An organisation with a turnover of $50m per annum is not necessarily going to have a sufficiently sized budget to justify having a dedicated treasury function," Isherwood said.

Around the world, even organisations fitting that description have run into serious trouble with interest rate swaps, and, like some farmers, have found their businesses left paying crippling interest rates.

Some farmers say they relied on their banks - notably National Bank and Westpac - for advice and did not understand the true nature of the risks they were taking on, though the contracts they signed stated they did understand and that the banks owed them no fiduciary duties.

The sale of the swaps to farmers, the scale of which is not yet fully known, is a hot topic among derivatives experts who believe the Commerce Commission needs to look at whether farmers had the sophistication, size, tools and support to "manage" their interest rate risk.

One said banks have sometimes insisted that larger

corporates wanting to manage interest rate risk through the use of swaps get specialist advice. When banks had concerns over the capacity of a borrower to cope with swaps, they have sometimes carried out due diligence on the borrower's treasury functions.

The commission has been told by another derivatives specialist that the swaps the farmers took out helped the banks manage the risks of their own, rapidly growing overseas borrowing, leaving them with large fixed interest payment obligations.

"It is apparent that the local banks receiving the hedge swapped New Zealand dollars have an asymmetric need to receive client fixed interest rate swap flows to offset those required to be paid under the terms of cross currency basis swap contract," he told the commission.

He believed this would provide a motive for banks to engage in "a concerted push" to engage borrowing clients into swap contracts to pay fixed interest to offset the banks' burgeoning exposure.

QUESTIONS EXPERTS SAY THE COMMERCE COMMISSION MUST ANSWER: 1. Were farmers advised it was prudent to protect themselves from spikes in interest rates when using swaps, and what did the banks selling swaps think was likely to happen with rates?

2. Did farmers understand the risks of the swaps, and did the banks take adequate steps to ensure they did?

3. Did the farmers have balance sheets large enough to cope with revaluations of their swaps, or the capacity to pay large break fees if their swaps soured?

4. How were farmers to monitor their swap position and make decisions to neutralise their exposure should rates move against them?

5. Did farmers realise that extra credit margins could be added by the banks should the revaluation of their swaps erode their balance sheet? 6. What risk modelling were farmers provided with, and did it accurately show the risks the farmers were taking?

7. What tools and ongoing support were farmers offered, and what support did they actually get?

8. What did frontline bank staff think they were selling, and are claims they did not understand the risks of the swaps fair?

9. What is the legal strength of the disclaimers that farmers signed? One National Bank document states: "Each party was capable of assessing the merits of an understanding (on its own behalf or through independent professional advice), and understands and accepts, the terms and conditions and risks of that transaction. It is also capable of assuming, and assumes the risks of that transaction."

10. Did the banks have any fiduciary duty to the farmers? One National Bank swaps presentation reads: "No party is acting as a fiduciary for or an adviser to the other in respect of that transaction." 12. Did the swaps sold to farmers differ from those used in the interest rate risk management programmes of large, sophisticated borrowers?